FFO, or Funds From Operations, is a measure of how much cash a real estate investment trust (REIT) actually generates from its business. It was developed by the National Association of Real Estate Investment Trusts (Nareit) because standard accounting profits can be misleading when applied to companies that own buildings, malls, warehouses, and other real property. If you’re evaluating a REIT as an investment, FFO is the number most analysts look at instead of net income.
Why Net Income Doesn’t Work for REITs
Under standard accounting rules, companies must depreciate their physical assets over time. A delivery truck loses value as it racks up miles, so writing down its worth on the books makes sense. But real estate is different. A well-maintained apartment building or shopping center can hold or increase its value for decades, yet accounting rules still require the owner to record depreciation as an expense every year. That paper expense drags down net income even though no cash left the company and the property didn’t actually lose value.
Because REIT asset structures are largely composed of real estate, their financial statements are heavily exposed to these non-cash depreciation charges. The result is that net income often understates how well a REIT is actually performing. Research published in the Journal of International Financial Markets confirms that FFO more accurately reflects actual REIT performance than net income does, at least for companies reporting positive earnings growth.
How FFO Is Calculated
The formula starts with net income as reported under generally accepted accounting principles (GAAP), then adjusts for items that distort the picture of ongoing operations:
- Add back depreciation and amortization related to real estate assets
- Remove gains or losses from property sales
- Remove gains or losses from debt restructuring
- Remove impairment charges on real estate
- Adjust for the company’s share of FFO from joint ventures it doesn’t fully control
The logic behind each adjustment is straightforward. Depreciation gets added back because, as Nareit’s own white paper states, historical cost depreciation of real estate is “artificial” and doesn’t reflect what’s actually happening to property values. Property sale gains and losses are excluded because they’re one-time events that don’t tell you anything about how the business performs year to year. The same reasoning applies to debt restructuring and impairment write-downs.
One important nuance: only depreciation tied to real estate assets gets added back. Nareit has clarified that depreciation on non-real-estate assets, like office equipment or vehicles, should not be added back. Depreciation on a computer is just as real for a REIT as it is for any other company.
FFO vs. Adjusted FFO (AFFO)
Many investors take FFO a step further by calculating Adjusted Funds From Operations, or AFFO. While FFO captures the cash a REIT generates before certain real-world costs, AFFO subtracts expenses that are necessary to keep the properties in good shape and the tenants paying rent.
To get from FFO to AFFO, you subtract three things:
- Recurring maintenance capital expenditures: money spent on roof repairs, HVAC replacements, parking lot resurfacing, and other upkeep that preserves property value
- Leasing commissions: fees paid to brokers who help fill vacancies
- Non-cash (straight-line) rent adjustments: accounting rules spread rising rents evenly across a lease term, which can make revenue look higher than the cash actually collected in a given quarter
AFFO is often considered closer to a REIT’s true “free cash flow” because it accounts for the ongoing cost of maintaining properties. FFO tells you what the portfolio earns before those costs. AFFO tells you what’s left after them. Both are useful, but if you want to understand how sustainable a REIT’s dividend is, AFFO is typically the better number to compare against the payout.
How REITs Report FFO
FFO is not a GAAP measure. It’s a supplemental metric, which means the SEC treats it as a non-GAAP financial measure subject to specific disclosure rules. Any REIT that reports FFO must also present GAAP net income with equal or greater prominence and provide a clear reconciliation showing how it got from one number to the other. The SEC formally accepted Nareit’s definition of FFO (as of its May 2016 version) as a legitimate performance measure and permits REITs to present it on a per-share basis.
Companies can also report modified versions of FFO with additional adjustments, but any tweaks must comply with SEC regulations. They cannot, for example, label a non-GAAP number with a name that makes it look like a standard accounting line item. This matters for you as a reader of earnings reports: if you see “FFO” in one company’s filing and “Core FFO” or “Normalized FFO” in another, the calculations may differ. Always check the reconciliation table to see exactly what was added or subtracted.
Using FFO to Compare REITs
The most common way investors use FFO is by calculating the price-to-FFO ratio, which works like a price-to-earnings ratio but with FFO in place of net income. You divide the REIT’s share price by its FFO per share. A lower ratio suggests you’re paying less for each dollar of operating cash flow the REIT generates, though what counts as “low” varies by property type. Industrial REITs, data center REITs, and apartment REITs all trade at different typical multiples because their growth profiles and risk levels differ.
FFO also helps you evaluate dividend safety. REITs are required to distribute at least 90% of their taxable income to shareholders, so dividends are central to the investment case. Comparing a REIT’s dividend per share to its FFO per share tells you what percentage of operating cash flow is going out the door. A REIT paying out 95% of its FFO in dividends has much less margin for error than one paying out 70%. When you layer in AFFO, you get an even sharper picture, since AFFO accounts for the maintenance spending the company can’t avoid.
One limitation to keep in mind: because FFO is a non-GAAP measure and companies can interpret the Nareit definition slightly differently, direct comparisons between two REITs aren’t always apples to apples. Checking the reconciliation notes in each company’s earnings report takes a few extra minutes but eliminates most of that ambiguity.